Domestic lobbying and foreign direct investment. The role of policy instruments

Abstract

Following the Common Agency approach to political equilibrium, we examine how domestic interest groups can influence national policies toward FDI and how the choice of instrument by the government can affect lobbying activities. Domestic firms lobby for lower subsidies when a discriminatory subsidy on FDI is applied. However, when a subsidy is applied uniformly to both groups, they may lobby for higher subsidies. The nature of lobbying is also different for proportional and lump-sum profit subsidies when uniformly applied. The qualitative effect of the number of domestic firms or the degree of corruption on the equilibrium depends on the choice of instruments. Finally, with the help of numerical simulation, we examine whether there is any potential conflict between the government and the lobby groups on the choice of the instrument.

Key Words:

• Foreign direct investment
• lobbying
• subsidies

Acknowledgements

The authors are grateful, for very helpful comments, to Devashish Mitra, Anjum Nasim, Pierre Regibeau, Somnath Sen, three anonymous referees, and to the participants at the annual conferences of International Trade & Finance Association, the Society for the Advancement of Economic Theory, and at the Hitotsubashi Conference on FDI and Trade.

Notes

Brander and Spencer (1987), Ethier (1986), Helpman (1984), Horstmann and Markusen (1992), and Motta (1992) are some examples to the first strand, while Grossman (1984), Haufler and Wooton (1999), Itagaki (1979), Janeba (1995), Lahiri and Ono (1998a), and Tsai (1999) are examples to the latter one. Some of the papers mentioned above can be fitted into both categories.

The literature has been surveyed in several works, including Magee et al. (1989), Rodrik (1995), Grossman and Helpman (2001), and Gwande and Krishna (2003).

The preferences of the consumers are represented by u(y, D) = y + f(D) where y is the consumption of a numeriare good produced under competitive conditions with a price equal to 1. There is also just one factor of production whose price is determined in the competitive sector. We denote the consumption of the non-numeriare good by D, while function f is increasing and strictly concave in D. The inverse demand function is derived from one specific case of the preferences mentioned above, i.e. u(y, D) = y + αD − βD ²/2.

Unfortunately, it is not possible to endogenize the numbers of both type of firms as then one group of firms – the ones with higher marginal costs – will be forced out of the market. One way out could be to relax the assumption that the goods produced by the two groups of firms are homogeneous as was done in Lahiri and Ono (1998b, 2003). In the appendix we have set up such a model and shown that some of the more interesting results in this paper would go through, albeit in a weaker from, in that model. Having said that, we should note that if domestic profits become exogenous, as they do in model presented in the appendix, there would be no reason for domestic firms to lobby. Given that in practice domestic firms do lobby and the fact that domestic firms in less developed countries tend to be internationally less mobile than firms from the developed countries, the model presented in the main paper is possibly more realistic than the one in the appendix.

This reservation profit can be reinterpreted as simply a sunk cost of investment.

For simplicity, we only consider domestic lobbying and rule out lobbying by foreign firms. This can be justified on the ground that in many countries, whereas it is perfectly legal for political parties to accept political contributions from the nationals of that country, foreign contributions to political parties are illegal. In some countries it is illegal for domestic firms to bribe abroad.

Using equations (5) and (6) the government's objective function can also be written as G = ρmC + (mπ ^d  − mC + V ^c ). Reorganizing the equation, we get G = (ρ − 1)mC + (mπ ^d  + V ^c ). Hence, the government attaches a positive weight to contributions provided that ρ > 1. In other words, there is no political relationship between the government and domestic firms when ρ = 1. Implicitly, we normalize the weight that the government attaches to social welfare to one.

As noted in the introduction, Bernheim and Whinston (1986) develop a refinement (see Lemma 2 of the mentioned work) in their menu-auction problem. Following this, first Grossman and Helpman (1994a) and later Dixit et al. (1997) develop a refinement (as in Bernheim and Whinston, 1986) for the political contribution approach, that selects Pareto-efficient actions.

Assuming A > 0 we have A(·) = C(·).

The structure of the model is similar to that of Lahiri and Ono (1998a) in which they consider a small country that designs optimal profit taxation and local content rules for foreign firms in the presence of unemployment in the host country.

When the subsidy is a proportionate profit subsidy, equation (3) takes the form of equations (16) and (17).

These conditions are derived before the symmetry in equation (2) is imposed. That is, a firm maximizes its profits taking the output levels of all other firms – (n − 1 + n ^f ) of them – as given.

The expression for the second derivative (evaluated at the optimum) is

• Substituting the first-order condition ((30)) in the expression above and reorganizing the result we find that if and only if (2ρ − 1)m(x ^f  + 2x ^d ) < 3x ^f (1 + m). This condition puts an upper bound on ρ. If ρ is very large, the government essentially does not care about social welfare and thus the optimal level could take a corner value.

To determine the effects on the equilibrium subsidy level, setting dG/ds equal to zero in equation (14) and using the implicit function rule gives , where θ = {m, ρ}. The above algebra will be used for comparative static analysis throughout the paper.

This result has some similarity with a result in Ono (1990) who showed that additional foreign penetration is welfare improving if foreign firms have more than 50 per cent of the market share. Here we examine the interaction between domestic and foreign penetration.

See, for example, Cramer et al. (1999) for details.